Social Networks

Subscribe

Top Blogs

Macroeconomics is becoming a pseudoscience, and that’s not good for us

Recently the FT’s Wolfgang Munchau referred to an article by prominent US economist Paul Romer, The Trouble with Macroeconomics, published in September 2016. Mr Munchau used it as an argument to rethink the conventional wisdom of macroeconomic management, such as independent central banks and inflation targeting. I agree we need a rethink, but Mr Romer’s article is the wrong jumping-off point for that idea. Instead Mr Romer shows that academic macroeconomics has lost touch with the real world.

Mr Romer references the Trouble with Physics an article from 2007 by Lee Smolin. At this time there was a lot of nonsense going on in theoretical physics, in particular with the idea of string theory. String theory attempts to be a theory of everything, and at its core is a lot of hard mathematics. But it makes no verifiable predictions and, indeed, seems to avoid areas where there is any danger that data might challenge it. It is more metaphysics than physics. And yet it commanded a sizeable academic following, including a number of big hitters – or at least it did in 2007.

Mr Romer suggests that something similar is happening in academic macroeconomics. People are creating elaborate models whose complexity runs well ahead of any data that can test their relationship to reality. This is covered up by sophistry and obfuscation. By itself this is not so strange, except that people are reluctant make public criticisms of these models, and the often prominent academics whose names attach to them. And yet that process of criticism is the stuff very of science. This makes it a pseudoscience – something that adopts the outward language of a science, but where a core set of beliefs and people are beyond criticism. (There is, of course, always a core set of beliefs in any system that are beyond challenge, including science, but I am talking about something wider here).

The prime target of Mr Romer’s criticism is a theoretical system referred to as the real business cycle. This was developed in the 1980s, and commanded supporters such as Chicago Nobel laureate Robert Lucas. It suggests that government actions, such as fiscal and monetary policy, have little effect on the real economy, and that the business cycle is almost entirely driven by changes to technology, a macroeconomists’ way of saying “just noise”. The real business cycle was presented to me as an economics undergraduate in 2006 as a curiosity that was so silly that it didn’t need comment or study. I can think of no serious piece of economic policy in recent years, and certainly since the financial crash of 2008, that makes reference to it. So it was a surprise to me to read that it remains the subject of serious academic support in the US – and that other serious academics look the other way rather than criticise it.

While Mr Romer spends most of his paper taking apart models based on the real business cycle, he makes it clear that this is a general problem, affecting Keynesian models too. And in particular the Dynamic Stochastic General Equilibrium (DSGE) models that are used for economic forecasting, and so hard-wired into economic management. Economists like to create huge models with lots of variables, and then pump huge amounts of data through them. But it is mathematically impossible to identify, that is to fix, the variables without building assumptions into the model about how they relate to each other – which the model is then unable to test. The models are therefore more a product of their assumptions than a test of those assumptions against data. Mr Romer complains of a conspiracy of silence not to undermine the fragility of all this. This ressembles string theory and other hobby horses of theoretical physics – though these days I read a lot about constructive work going on in physics, as scientists grapple with the problems of dark energy and dark matter. Also I think theoretical physicists are much more transparent about what they are doing – so far as I can see they aren’t even pretending that what they do is useful, except in some abstract sense of advancing the boundaries of human thought. Macroeconomists are dishonest by comparison.

How has all this come about? I don’t think it helps that macroeconomics has been politicised, and in the highly polarised environment of US politics. Real business cycle models are beloved of the right, as a basis for cutting government down to size; DGSE models are liked by the left, as the basis of fiscal and monetary intervention. Pretty much any important development in macroeconomics is parsed for its political significance. Neutrality does not seem to be an option – and yet cloaking policy prescriptions in academic mumbo-jumbo make them look more authoritative, and so demand for academic economists remains strong. US academics used to knock seven bells out of each other (the famous dispute between “salt water” and “fresh water” institutions) – but no doubt they now realise that this just devalues the whole discipline, and so the different schools ignore each other instead. Besides, they both rely on similar conceits.

How much does this matter? Those involved in the practical business of running economies have long since ignored real business cycle theory. Econometric models are used, but with a great deal of caution. Alternative ways of constructing models might be fruitful (for example Kingston’s Professor Steve Keen suggests the use of non-equilibrium complexity theory, as used in meteorology) – but these are liable to suffer from same identification problem. The future is inherently unpredictable. Practical economists can get on with the job without help from an increasingly irrelevant academia.

And yet there is a clear crisis in economic management. Too many people in developed economies feel left behind, fueling political instability that will not help economic management. The authority of the western democratic and inclusive system of government is waning as a result. If academic macroeconomists coud somehow change the direction of their discipline, rather than resorting to obfuscation to insist they were right all along, and deluding themselves that massive computer models are telling us anything useful, then the outlook would be better.

7 thoughts on “Macroeconomics is becoming a pseudoscience, and that’s not good for us”

Anyone who follows Physics through journals such as the New Scientist will know that Physicists generally will have heated discussions and even arguments. But, equally generally, at the end of these there will be a movement towards consensus. So we don’t have different ‘schools’ in Physics. We don’t have bodies of opinion saying that Schrodinger or Einstein was wrong etc.

That’s because Physics is essentially what I would term a ‘clean’ discipline. The powers-that-be aren’t really interested in gravitational waves or the sub nuclear particles , like the well known Higgs Boson, that are studied in the Large Hadron Collider. They aren’t threatened at all by the findings. So they are content to keep out of it.

The exception to all this is climate science, of course. Climate Scientists, many of whom are Physicists too, weren’t at all prepared for the politicisation of their chosen field of of study. They expected that they could safely publish their findings of dangerous global warming free from political interference. That was somewhat naive and obviously a big mistake on their part.

They should have perhaps spoken to economists who’ve been putting up with political interference for years. There may be no obvious censorship, but when Robert Lucas takes a nonsensical position such as you’ve quoted, ” that government actions, such as fiscal and monetary policy, have little effect on the real economy” he knows he’s going to be looked upon much more favourably than if he’d taken a contrary position.

But he’s not a Nobel Laureate -strictly speaking. The Prize in Economics is not one of the original Prizes created by Alfred Nobel’s will. The economics profession obviously felt somewhat miffed at being omitted so the Swedish Central bank stumped up the cash so they could be included too. In other words, having no formal invitation, they gate crashed the party! An economics prize would have been fair enough if they’d called it something different to a Nobel Prize.

The dispute in economics isn’t between “DGSE models (which) are liked by the left, (really? -PM), as the basis of fiscal and monetary intervention” and the obvious nonsense of “Real Business Cycle” models.

For a start DGSE models are essentially a New Keynesian construction. I always make the translation to NOT Keynesian when I hear that term. None of these models predicted the 2008 crash – but it was obvious to many of us that this was on its way a couple of years earlier. I don’t make any claim that I knew just why it was on its way but the run-up to the crash just felt very much like the run-up to the Lawson induced crash of the late 80’s but this time on a global scale.

It was the bursting of a private debt bubble. Fisher Debt Deflation. This had been known about since the early 30’s? So the mainstream should have known better than anyone else that it was coming. When the Queen famously asked the LSE professors why they hadn’t been better informed it was rather like a reversal of the story of the Emperor’s clothes. Except it was the Empress saying the small boys at the LSE had no cover.

If you want to know how the economy really works you need to pick up where the profession was in the 60’s and early 70’s. Before it went off the rails due to political interference. It must be obvious to anyone with any intelligence that it has gone wrong. Big time!

Just who in their right mind would advocate such a system as the eurozone? Who could possibly think that countries like Greece and Germany could possibly share a common currency? Where was the warnings from the mainstream about the folly of this? There were warning but they came from those who were prepared to pay the price of the loss of their own careers. Such as this:

Well Smolin did not take such a benign view of physics. Having said which, all that I have seen of physicists on the TV or radio follows the picture you paint. They don’t seem to mind that the theory that is their life’s work might be disproved by new data – bring on the day, they say. Economists come across differently. I don’t just think that it is because it is politicised (i.e. too important to be left to such high-mindedness) economics itself is much less susceptible to being tested against data. Every pair of similar sequences of events has a near infinite number of differences. Nothing truly repeats.
I think there were a few people who saw the crash of 2008 coming (I myself was convinced enough to switch my pension fund into index-linked gilts in 2007 after the interbank market froze over). But most economists took a very narrow view of their remit – pricking bubbles was not among them. Vince Cable says that he got a stern warning from the Treasury that he might create panic when he started talking about it. The people I really have it in for are the geeks who used bell curves to model market risk, and so assumed massive movements were impossible.
The economists in the 60’s and 70s were badly wrong too – that’s what gave the monetarists et al their opening. They failed to understand how economic capacity moves along with underlying technological developments. So they thought Keynesian stimulus could dig us out the oil shock, and created stagflation instead. Left-leaning economists now have a similar problem, in my view, and aren’t learning from the mistakes of that era.
And as for the Eurozone, I wouldn’t blame economists for that. I remember because I supported the project, and was very conscious of the waves of scepticism coming from the direction of most conventional economists (and especially the types that took over in 1980s). That scepticism was alive and well when I did my degree at UCL in 2005-08; the politicians overruled them and found a few second-raters to back them up. After all isn’t it just crazy to think that the economies of New York, California, Alaska and Louisiana could possibly share a common currency? Anybody who could have think that the US economy could be successful based on such a crazy notion should be sent to the funny farm.

. After all isn’t it just crazy to think that the economies of New York, California, Alaska and Louisiana could possibly share a common currency?

Well no it isn’t because the USA is a single country.

The Federal Govt collects income tax and is responsible for most welfare payments. This acts as a fiscal equaliser. I’ve just checked and unemployment ranges from about 3% in North Dakota to just over 7% in Mississippi. Which is of course a much smaller spread than we find in the separate economies of the EU countries.

Of course, in my clumsy use of irony I was not denying that the US was a successful economy, notwithstanding the diversity of the different states. This is one of the things that supporters of the Euro had in mind. As you say, the US has a much higher level of interstate transfers than the EU, but are they that high in fact – the US has low taxes and mean welfare? Is it sufficient to explain the convergence of the unemployment rates (I might at that it might be more helpful to look at employment rates of working age residents). Remember also that the US states have much tighter fiscal rules than even the Eurozone does. Back in 1990s I think supporters of the Euro thought that integration of product markets and labour and capital mobility would be enough.

But were they? For most of the 60’s, unemployment was never much higher than 2%. This included the whole of the UK even the remote areas where unemployment was higher. That was a genuine 2% too. Everyone was counted then. Now there is a long list of reasons why certain categories of unemployed aren’t counted.

So in retrospect in can be argued that 2% was too low and led to the economy becoming overheated especially in the more prosperous regions of the UK. The Government should have had more spending in the regions and less in London and the SE of England. Incidentally, that’s probably still true.

The sudden jump in oil prices in the 70’s added a further shock to the system. On a world wide scale, if the oil exporters were taking in more dollars, but not spending more dollars than they were spending previously, that was going to add a considerable strain to the system. There was a move to “recycle the petrodollars”. But another way for the west to rebalance the system was to allow the price of manufactured goods to rise. In other words prices had to rise in response, or in retaliation, to the rise in oil prices.

Even Germany had close to double digit inflation at the time and they’ve never been big on Keynesian economics!

So what happened in the 70’s isn’t at all inconsistent with the dominant Keynesian perspective of the time. Of course, there were plenty of conservative economists who seized the opportunity to argue otherwise. Keynesian economic policies, for them , were for emergency wartime use only. As soon as WW2 ended then they should have ended too. They would have been very unhappy that it took until the mid 70’s to start to do that. The high inflation of the time was a convenient excuse.

That’s quite a heroic defence of 1970s Keynesianism. But the conventional wisdom of the time it was impossible to have high inflation and high unemployment at the same time. It took Milton Friedman’s idea of equilibrium unemployment to bring order back into the chaos at least in theory (about the only good idea that man had); that idea led to inflation-targeting, an idea that in its turn has run its course. Samuel Brittan, who was very much part of the economics elite of the time, wrote looking back that the big mistake of the era was not to recognise when the economy had run out of slack. They had no idea that loose fiscal and monetary policy would be inflationary, because they thought the economy had plenty to spare. In my view the 1960s and 1970s had close to full employment because of a convergence of benign demographic and technological factors. This was the era when many consumer products were invented, unleashing massive potential to increase consumer demand; meanwhile this involved the creation of millions of blue and white collared jobs within the capability of the education system to fulfil. By the 1960s that was running its course….

‘In the early 1980s, the British Tory government, allied with increasingly conventional economists at Cambridge, began “sharpening its knives to stab Wynne [Godley],” according to Kumaraswamy Velupillai, a close friend who now teaches at the New School in New York. They killed the policy group he headed and, ultimately, the Department of Applied Economics.’

‘The Times of London called him “the most insightful macroeconomic forecaster of his generation” — though often as a renegade.’